Investment Update: It's Not the Heat, It's the Humidity

Investment Update: It's Not the Heat, It's the Humidity

December 2015


In his December Investment Update, BNY Mellon Wealth Management's Jeff Mortimer discusses how the pace and the ultimate start date of the Fed’s first interest rate increase may influence the future of the equity market.

As the cold starts to make its way into New England, many of us are contemplating vacations to warmer, more habitable climates, like Florida. Anyone who has visited the Sunshine State, or the eastern seaboard during summer, can appreciate the true meaning of the title of this piece. As we await clarity on the Federal Reserve’s (Fed) decision to raise rates, I believe this is an apt analogy to compare the Fed’s first rate hike (the heat) versus the pace at which it will continue to increase short-term interest rates (the humidity).

Though the timing of the first rate hike has been much debated, we expect that the first rate increase is drawing near. Recent strength in economic data, especially the November non-farm payrolls jobs report, which showed the creation of 211,000 non-farm jobs and an unemployment rate to 5.0%, supports our belief that the Fed will be ready to raise rates at its December meeting. Fed officials have been vocal as of late, seemingly to prepare markets for its first rate hike in nearly a decade. Fed Chair Janet Yellen commented that a December hike is a “live possibility” if incoming data is supportive of a growing economy, improved labor markets, and a return to 2% inflation. With the December FOMC meeting nearing, let’s discuss the raised expectations of the long-awaited hike, what it means for the markets, and what factors will matter most once the Fed begins to normalize interest rates.

Never in my career can I remember any event receiving as much coverage as the date of the Fed’s first interest rate increase.

Jeff Mortimer, Director of Investment Strategy

It’s the Pace that Matters

It is almost impossible to imagine that the market has not already priced in the most debated rate hike in history. Markets rarely discount the same news twice, so I believe it is unlikely that there will be a strong market reaction once the Fed begins to raise rates. Figure 1 illustrates stock market performance under various tightening scenarios dating back to 1946. On average, stocks are up around 3% a year following the first hike during all tightening cycles.


Figure 1: Slower Fed Tightening Cycle Anticipated
S&P 500 Around Start of Fed Tightening Cycles Since 1946

Slower Fed Tightening Cycle Anticipated

Source: Ned Davis Research. Slow cases include: 4/25/46, 4/15/55, 9/12/58, 7/17/63 and 8/31/77.Fast cases include: 11/20/67, 1/15/73, 9/4/87, 2/4/94, 6/30/99 and 6/30/04.


History also says that the pace of rate hikes matters. When the Fed exercises patience with its rate hikes, the market rewards amply with returns of around 11% on average one year after the Fed’s first move. It is only when the Fed moves quickly that equity markets suffer, losing about 3% one year later. The data clearly show that the pace of the rate hikes, not the ultimate start date, influences the future return of the equity market.

Many Fed governors have conveyed that the pace of hikes will be slow and measured, but promises are one thing—following through is another. Inflation is the key variable that will have the most impact on the pace of future rate hikes, and for now, all signs point to continued low inflation. Two interrelated drivers of continued low inflation have been modest wage growth and the low velocity of money. While wage growth is beginning to exhibit some signs of strength, the velocity of money is not.

Year-over-year wages have steadily increased since the 2011 growth scare, but unlike prior cycles, wage growth has not yet been inflationary. One reason for this is because recent wage growth seems to have been pocketed by employees and not spent. This is evident in the relatively high savings rate of 5.6%—a level not seen at this point in an economic recovery in 20 years. High savings rates also influence the velocity of money, which is broadly defined as the average number of times a dollar is used to purchase a final product or service during a given time period. There are fewer transactions when individuals save instead of spend, leading to lower velocity of money. Low long-term real interest rates have also provided little competition to money market funds, CDs, and savings accounts. Rather than investing that money in longer-term bonds, which would have allowed that money to be recycled back into the economy more effectively and thus increase velocity, investors elected to hoard money in cash. Individual investors, in a sense, have been following in the footsteps of corporations, which have built large cash balances in order to be better prepared for future liquidity needs.

We will continue to monitor these two variables going forward. For now, it seems rising wages are being reserved for building war chests. While increased savings does not spur economic growth, it does tend to keep a lid on inflation in check, and that’s good news if you’re Janet Yellen.

This material is provided for illustrative/educational purposes only. This material is not intended to constitute investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of all of the investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.

BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation.

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